How Chinese Commodity Financing Deals Work, And The Worry Behind Them

The widespread use of commodities like copper and iron ore as loan collateral has drawn attention and concern from the Chinese government and markets.

There has been a great deal written in the press over the past few years about Chinese commodity financing deals (CCFDs) and their effects (or not) upon various different commodity markets. Most recently, particular focus has been on the iron ore and copper markets.

When writing about the FANYA Metal Exchange last month, I suggested that the exchange and the stocks of metal it “holds” may actually be a nifty way for China’s State Reserve Bureau to complement—with “buffer” stock financed by exchange members—the country’s national stockpile of such metals.

Looking at the whole subject of CCFDs, however, I started to wonder whether some of the stocks held in FANYA’s warehouses might not also be collateral for commodity financing deals.

What Are CCFDs?

The use of various commodities in financing deals has been around since time immemorial; maybe, in the case of copper, for as long as the metal has been available to humans in tradable form. And that would be a very long time, as copper is the world’s oldest mined commodity.

The simplest commodity financing deals involve the use of a commodity as collateral (or security) for a loan. Failure to pay results in the lender selling the commodity. In the early days, the “commodity” could have been anything: wine, grain, livestock, metal, precious stones etc.

These days, such collateral is much more likely to be something with a high value-to-density ratio, such as gold, silver, nickel. It should be as cheap as possible to store and, as importantly, should not degrade over time.

So, while both soybeans and palm oil and even rubber have historically and even recently been used as collateral in financing deals, they certainly are not favored as such. (Indeed, the recent default by Chinese importers on 500,000 tons of U.S. and Brazilian cargoes of soybeans (being used as collateral) posed a threat to the soybean market itself.) In addition, an article in the mid-May Nikkei Asian Review mentioned that even semiconductors have been used.

Commodity financing deals these days can, but do not need to, be somewhat more complex. However, the basic principle underlies all such deals—the use of commodities to secure finance. In a “carry trade,” a borrower uses the commodity not only as security for a loan, but also, at the same time, to make money.

For example, in a favorable contango market, a commodity can simultaneously be bought physically using borrowed money, and sold forward. If the price for which it is sold is sufficient to cover the interest on the loan, the loan itself, storage charges, insurance etc., and more, then, when it comes time to repay the loan and deliver the commodity, the “and more,” will be locked-in profit.

As will be obvious, for as long as conditions remain favorable, such an arrangement can be extended simply by rolling it over, locking in a profit each time it is.